Forex Weekly Trading Forecast - 02.07.11

US Dollar Sees a Bounce but Fundamental Support is Lacking

By John Kicklighter, Currency Strategist

Fundamental Forecast for the US Dollar: Neutral

• The unemployment rate may have dropped to a 21-month low; but the outcome is far from encouraging
• Both service and manufacturing sector activity surveys swell in January, but is this growth?
• View our six-month US Dollar Outlook

The dollar has come a long way in just a week’s time. Through the second half of this past week, the dollar was starting to find its footing in what looks to be a tentative recovery. Yet, doubt over whether this is a true, bullish reversal should be preserved considering we had similar speculative hopes dashed just a week before when a sharp rally for the dollar and the long-awaited channel break from the S&P 500 were subsequently reversed after the weekend. What led the greenback to gain ground this past week is what we need to establish. The deeper the fundamental roots to this effort, the more probable carry through will be on a true bull phase. That said, without a solid foundation, the benchmark currency could be up for another swift tumble.

Looking over the past week, the dollar could have drawn its strength from two particular sources: high-level event risk or risk appetite trends. The data flow was particularly interesting for its rounded look at the broader economy. A view of the consumer and business health offered a direct look into whether the US economy was on a fast track to surpass its global counterparts for growth and returns. Where personal spending, manufacturing activity and service sector activity all carved out gains; a vigilant fundamental trader would really hone in on the disappointing employment breakdown and the PCE-based inflation figures. Where the net payrolls were a disappointment for missing their mark; the jobless rate only improved with a record frustrated American’s leaving the labor force and the participation rate tumbling dot its lowest level in 26 years. This puts growth into perspective. Without employment and wages improving, the economy will not continue to expand at its current clip. And, as for the Fed’s favored inflation indicator, a record low sets a very poor precedence for interest rate speculation.

Data was not very encouraging last week; so perhaps the dollar took the initiative to capitalize on a risk aversion move. And yet, our benchmark for sentiment (the S&P 500) was still pushing two-and-a-half year highs. Going forward, it will be exceptionally difficult for the dollar to sustain – much less leverage – its burgeoning rally if sentiment does not start to deteriorate market-wide. There are just a few prominent catalysts that can meaningfully encourage the greenback higher at this point; and risk appetite trends is at the top of the list. An ideal situation for the safe haven currency would be an aggressive and correlated tumble in equities, corporate debt and speculative commodities along with a subsequent rally in gold, money markets and the funding currencies. One or two of these factors would present limited backing. As for the data on hand, don’t expect meaningful volatility to follow the releases. Consumer credit will take measure of lending conditions, the NFIB small business optimism will gauge hiring expectations for the largest employer group, the monthly budget will track the push to the deficit cap and the University of Michigan sentiment survey will gauge Americans’ willingness to spend. None of this though materially alters the US’s relative pace of growth, risk appetite trends or the timing for rate hikes.

And, though as traders, we should take stock of the immediate threats on our radar; it is also important to keep tabs on the longer-term developments. Concerns that will weigh more heavily in the not-so-distant future are the underperformance of domestic yields, the burden of a record deficit and the eventual withdrawal of stimulus. Just keep those concerns in mind. – JK

Euro Stages Major Turnaround – is this the Reversal?

By David Rodriguez, Quantitative Strategist

Fundamental Forecast for Euro: Bearish

- Euro extends decline on dovish European Central Bank commentary

- Euro at risk of an important reversal amidst price/sentiment divergence

The Euro saw a potentially significant reversal against the US Dollar through late-week trade, threatening a larger correction as it failed to hold highs and finished lower through Friday’s close. Markets initially sent the downtrodden US Dollar sharply lower against the Euro and other major currencies through Monday’s open, but a later reversal suggests short-term momentum may have turned in the Greenback’s favor. Of note, the Euro/US Dollar set a potentially significant “Evening Star” reversal formation as it failed to hold fresh multi-month highs on two consecutive trading days and closed sharply lower on the third. A surprisingly dovish European Central Bank interest rate decision may have been the catalyst to force a larger move lower in the previously high-flying EURUSD.

Euro volatility expectations have dropped considerably as a highly-anticipated ECB rate decision and US Nonfarm Payrolls result have come and gone, but that hardly guarantees slower price moves in the days ahead. If this is indeed a potential reversal point, price action will almost certainly be choppy and sharp intraday swings are likely. Foreseeable European economic event risk is nonetheless limited to mostly second-tier economic releases. A potential exception comes on an often-unpredictable ECB Monthly Report due Thursday morning at 09:00 GMT. Given the euro’s sharp reactions to recent ECB rhetoric, any surprises could force important EURUSD swings

European Central Bank Governor Jean Claude Trichet surprised markets as he expressed a relatively dovish tone on inflation through Thursday’s announcement. The euro had previously rallied on expectations that the ECB may soon move to raise interest rates on growing price pressures within the EMU. Yet Trichet all but quashed such speculation as he underlined the relatively benign trend in core price inflation. Overnight Index Swaps now predict that the central bank may move rates through the second half of the year at the earliest, and the euro has fallen in kind.

The top question on traders’ minds is clear: is this the start of a larger Euro/US Dollar correction? Our technical strategists certainly think that this may be the spark necessary to force a major EURUSD turnaround. The fundamental picture remains less clear, but a relatively positive result in US Nonfarm Payrolls data suggests the US recovery may be picking up steam. The headline NFP change missed consensus forecasts by a wide margin. Yet inclement weather across the country meant the survey likely understated job growth to a similarly large extent. It will be critical to see how the EURUSD starts the week’s trade, as this may set the tone for following days and subsequent weeks through February. - DR

Japanese Yen Weakness Could Be Short-Lived, Consolidation Ahead

By David Song, Currency Analyst

Fundamental Forecast for the Japanese Yen: Neutral

• US Dollar at Risk of Further Losses vs British Pound, Yen
• Japanese Yen Takes an Economic Blow after Government Officials Says Double Taxes
• Japanese Yen Looks to Once Again Play the Role of Funding Currency and Safe Haven

The Japanese Yen weakened against the U.S. dollar for the first time in four weeks, with the exchange rate advancing to a high of 82.45 on Friday, but the near-term rally in the USD/JPY could be short-lived as the pair continues to trade within the downward trend channel carried over from January. The DailyFX Speculative Sentiment index continues to reinforce a bearish outlook for the dollar-yen as retail traders remain heavily net long against the pair, and the exchange rate may pare the advance from earlier this month as investors diversify away from the greenback.

Meanwhile, former Bank of Japan official Masayuki Matsushima warned that the “bond bubble” may burst over the medium-term as the government struggles to manage its public finances, and implored the administration to “increase the consumption tax rate” after Standard and Poor’s cut the region’s credit rate to AA-. As Japan holds the top seat amongst the industrialized countries for the largest budget deficit, the tepid recovery could make it increasingly difficult for Prime Minister Naoto Kan to manage the risks for the region, and the central bank may weigh different alternatives to stimulate the ailing economy as it aims to promote a sustainable recovery. As the marked appreciation in the exchange rate continues to dampen foreign demands, the BoJ may look to intervene in the currency market once again as the benchmark interest rate remains close to zero, but the technical outlook continues to reinforce a bearish outlook for the USD/JPY as the pair fails to retrace the decline from the previous month.

The USD/JPY appears to be in a small consolidation phase as the technical outlook continues to point to further decline, and the exchange rate may trend sideways over the near-term before we see another break to the downside. As the rebound in the dollar-yen tapers off ahead of the upper bounds of the downward trending channel, currency traders may take advantage of the range-bound price action over the following week, and the pair may continue to retrace the rebound from back in November as the U.S. dollar struggles to regain its footing. - DS

British Pound: Risk Trends May Undermine Gains from Hawkish BOE

By Ilya Spivak, Currency Strategist

Fundamental Forecast for British Pound: Neutral

• UK Manufacturing Expands at Record Pace in January
• Candles Hint at British Pound Top Below 1.62 vs Dollar

Monetary policy is firmly in focus in the week ahead as the Bank of England delivers February’s much-anticipated interest rate decision. The announcement takes on special significance considering it will coincide with the creation of an updated quarterly inflation forecast, promising to bring some much-needed clarity to the ongoing debate about how policymakers plan to reconcile stubbornly high inflation with already sagging growth that is facing additional headwinds as the impact of the government’s austerity program continue to filter into the overall economy.

For their part, traders appear to be increasingly positioned for a hawkish outcome. Indeed, a Credit Suisse gauge of priced-in rate hike expectations over the coming year stands at the highest in a year. This seems reasonable. While GDP growth certainly disappointed on a quarterly basis in the three months through December, overall growth in 2010 outdid the central bank’s forecast calling for a 1.17 percent annual increase, adding 1.6 percent. Meanwhile, inflation stands at an eight-month high, challenging the central bank’s credibility as a bulwark of price stability considering Mervyn King and company spent most of last year promising that CPI would retreat on its own only to see it continue to march upward. Minutes from January’s BOE sit-down reinforced signs the likelihood that policymakers would err on the side of price stability, opting to handle the threat of a back-slide into recession when and if it materializes. On balance, this opens the door for a move higher for the British Pound.

The outlook for interest rates will not be uncontested as the top driver of Sterling price action however, with GBPUSD showing a firmly re-established correlation with trends in underlying risk appetite (as tracked by the MSCI World Stock Index). This seemingly points to weakness for the UK unit as traders digest the details of the US employment report released on Friday. Shares finished higher on Wall Street as investors opted to focus on the drop in the unemployment rate rather than the underwhelming increase in payrolls, but this may quickly dissipate as it becomes apparent that the decline owed to an exodus of discouraged workers from the labor force rather than any kind of improvement. Indeed, the labor force participation rate dropped to the lowest since March 1984. If the lackluster outcome for the world’s top economy – long the bellwether for global growth at large – rekindles risk aversion in earnest, GBPUSD may find itself facing acute selling pressure regardless of how the BOE opts to proceed.

Source : www.dailyfx.com